Technical Analysis: What you Need to Know Before you Look at a Chart?

 

Before you delve into the world of double bottoms, head and shoulders, flags, triangles and wedges you should first try to understand the background to technical analysis (TA). By accomplishing this you can decide if this potentially powerful tool is for you and how it could help guide your trading and investment decisions.

 

 

What is Technical Analysis?
Technical analysis is the study of price data and statistical indicators that are formed by market activity. Market activity illustrates the flow of supply and demand. This supply and demand is a reflection of beliefs and opinions translated into human behaviour and specifically, herd mentality. Therefore, technical analysts would argue, price patterns and indicator signals can be categorised based on historical data with a reasonably high expectation that they will occur again at some point in the future. This argument is based on the theory that human behaviour is innate and, although it adapts and evolves over a long enough period of time, it remains basically the same. Technical analysts focus on the herd mentality and how it affects the individual. It is after all very difficult to hold an opinion contrary to popular consensus especially in an arena where you have to make your opinions know, as you do in the financial markets (in the form of trades).

 

A Little Bit of History Repeating
Mark Twain (the American humorist, writer and lecturer) once said that “History doesn’t repeat itself-at best it sometimes rhymes”. This is true for the subject of this article, technical analysis. Although TA is based on using patterns that have previously occurred to predict the moves of the future no two patterns are ever exactly the same. How can they be when you list the variables that determine price action: trading methodologies, the number of participants, the participants themselves, order sizes, market liquidity, the list goes on. We all know that no two pairs of eyes are ever the same but they are similar enough for you to recognise which are blue or brown etc. The same can be said for price patterns and indicator readings; no two are ever exactly the same but they are similar enough that they can be classified and you can draw a prediction as to where prices are likely to move on completion.

Self-Fulfilling Prophecy
One of the major debates surrounding technical analysis is that it is self-fulfilling. Therefore if enough people use TA and trade the set-ups then they will influence the move they endeavoured to predict in the first place, thus harming its effectiveness. It doesn’t really matter which side of the fence you sit on here, the fact is that a degree of self-fulfilment is inevitable but it doesn’t necessarily guarantee the success or failure of the method. If a price pattern emerges it is not as though every technical trader defines exactly the same entry point and pulls the trigger at exactly the same time or the market would not function. Price would jump instantaneously causing massive slippage and partial fills and then collapse as traders took their profits. The opposite of this would of course be true if technical analysis was deemed as a poor method of analysis. In reality we find ourselves at a happy medium. With enough technical knowledge, a robust trading formula and practical pattern recognition you have a strong basis for a profitable edge. The fact that traders use different entry techniques, price patterns, technical indicators or no technical analysis whatsoever means that there is just enough self fulfilling prophecy present to give technical analysis profit potential.

Market Psychology and Herd Mentality
Moving away from the idea of the self-fulfilling prophecy is the analysis of market psychology and herd mentality. Your ability to read this is an integral part of trading. Technical analysis is designed to give us a means to define this psychology and the resultant market action in the form of price or indicator patterns. We can use these patterns to make a prediction as to the next likely direction price will adopt. Therefore TA is saying that herd mentality is predictable to a degree and does repeat itself with enough accuracy in order to highlight trade opportunities.

A Place for Fundamentals
There is always a place for fundamental analysis in trading, even if this analysis is as basic as knowing when data will be released. In just the same way that technical traders react differently to the same price chart, fundamentalists will react differently to the same piece of news. Market reaction to fundamental news can be unpredictable and violent and the resultant price action will add another variable to the potential success of technical analysis.

Technical Analysis and Timeframes
Technical analysis can be used on all time frames. The general consensus is that the most significant price patterns and indicator set-ups are the ones that occur on the longer time frames, such as daily or weekly charts. Whether you decide to use short, medium or long-term time frames will depend on your characteristics as a trader. However it is always prudent for traders to analyse all timeframes so they can be aware of the full technical picture. It is the short-term price action that that paints the long-term picture and the long-term picture that has a determining effect on short-term moves.

Implications for Technical Analysis and Trading Systems
When using technical analysis to design a trading system it should be remembered that a price pattern is not an ATM machine. Technical analysts focus on predicting the future using observations of the past. However it is more effective to see TA as simply a means to determine entry and exit points. At first glance you may think that attempting to predict the future and determining entry and exit points are the same thing, but altering the phrase you use to describe your objective brings about a profound psychological change on your part. Predicting the future via the use of past examples ultimately leads to your prediction being right or wrong. Not only do we humans hate to be wrong but we hate it even more when we stake money on it. Without going into too much detail about trading psychology (we’ll leave this for another article) almost any emotion whatsoever can have a negative bearing on your trading. Losing a trade (and money) will make you go back to your technical analysis book and library of price charts to find out what on earth went wrong. You will undoubtedly see that the pattern you used for your entry was slightly different (it always is, we have already touched on why) and therefore you could have entered differently or not at all. This is the first stage of doubting your edge which can lead to all sorts of problems. Now suppose your pattern was just an entry point: If you have set your risk and target based on solid money management then you have given yourself the opportunity to profit from the potential you have identified, nothing more, nothing less. Now you must wait for an exit signal or for your target/ risk threshold to be reached. In effect you are reacting to signals the market gives you or flowing with the market. You are participating and not anticipating. Therefore you cannot be right or wrong. Ego, fear and greed will not play a part in your decisions.